The increased churn rate also has tax consequences for holders of passive index funds.

The S&P 500 index includes 500 large-cap companies that are traded on the American stock exchanges and covers about 80% of the U.S. equity market by capitalization. The S&P 500 is used widely as a barometer for U.S. large-cap equities, and many investors hold S&P 500 mutual funds or ETFs in their investment portfolios. What many investors, including those who hold individual equities, may not be aware of is the amount of turnover or churn within this index and what this may mean for your investments. For example, in 1935 the average lifetime of a large-cap company in the S&P 500 was 90 years. But in a report compiled by Richard Foster of INNOSIGHT, by 1958, that lifetime had declined to 61 years, and then declined further to 25 years by 1980. Today the average lifetime of a company on the S&P 500 is only 18 years (see Figure 1). Over the past decade, 50% of the S&P 500 has been replaced, and at the current rate of replacement, an S&P 500 company is being replaced about once every two weeks. If the trend continues, approximately 75% of companies on the index will be replaced by 2027.

Figure 1: Rolling seven-year average lifespan of companies on the S&P 500 index. Fifty percent of companies have been removed from the list in the past decade, and another 75% are projected to be removed by 2027. Source: INNOSIGHT Executive Briefing

For example, in 2014 alone, 15 companies were removed from the S&P 500 as they were replaced by new entrants to the list. In prior years, 23 companies were removed in 2011 and 18 each were removed in 2012 and 2013. And these are not just smaller companies on the index that you may never have heard of. Rather, companies removed over the years include many iconic American names such as Eastman Kodak (EK) in 2010, RadioShack (NYSE:RSH) in 2011, the New York Times (NYSE:NYT) in 2010, and Sears (SHLD) in 2012 (see Figure 2). While some companies are removed due to acquisitions, many are removed because they no longer qualify because of market capitalization declines.

According to Foster, the term "creative destruction" was coined by the Austrian-American economist Joseph Schumpeter (1883-1950) to describe the turmoil associated with economic progress in capitalist societies. As applied by Foster, innovation often conflicts with established businesses, which can fall behind the pace of changes as new companies, technologies, and business models emerge.

So how does a long-established company continue to thrive? One approach would be for a company to have a wide economic moat, a term coined by Warren Buffett to describe businesses that are difficult for new competitors to gain entry to, either due to the sheer scale of the enterprise (e.g., railroads) or to an exclusive patent or other such competitive advantage.

Another approach, according to Foster, would be for a company to embrace creative destruction by finding ways to stay relevant by envisioning itself as a market and then creating and trading its assets within its own market. There are not many companies that have embraced this concept of creative destruction, but Foster points out that Procter & Gamble (NYSE:PG) is one of the rare companies that is successfully doing this now through its well-established ability to innovate and to divest or trade its various product lines. Although the company has close to 200 brands in its portfolio, only 70 to 80 of those brands account for 90% of net sales, and the company recently announced that it plans to shed about 100 brands that have minimal impact on its revenues (e.g., Duracell).

This is not the first time that PG has engaged in such a practice, as it previously sold off its food product brands in the early 2000s, including Jif, Crisco, and Folgers, which it sold to J.M. Smucker Co. (NYSE:SJM), and more recently selling Pringles to Kellogg (NYSE:K). According to Foster, PG has been successful at using the "create, operate, trade" strategy to free up capital, to innovate its core brands, to enter new areas of business, and to maintain tight control over its margins. International Business Machines (NYSE:IBM) is another company that is currently embracing this strategy, but it has not been as successful as PG to date as it struggles to adapt to a rapidly changing technological economy. I recently covered IBM in an article here.

Actions For Investors

The purpose of this article is to bring awareness to investors regarding the increasing churn rate of stocks and the shortening lifespan of companies in the economic market today. This is particularly relevant for shareholders in individual equities, including the "safe" blue chips where rapidly evolving technologies and new business processes could be disruptive for even the most stalwart of iconic companies. For conservative, long-term investors, it is important to look for companies that not only have economic moats, but that are also actively engaged in innovating. As Dominic Barton, managing director of McKinsey & Co, recently noted in Fortune, rapid change is attacking the existing business model. Thus for continued success, companies need to cannibalize themselves "to make business disruption part of [the] performance metric."

But the increasing churn rate in the S&P 500 should also be noteworthy to investors in index mutual funds as well, even if you hold passively managed index funds such as the S&P 500 index. Why? Because as companies move in and out of the S&P 500, the mutual fund is forced to buy and sell stocks in those same companies so as to match the index. The selling by the fund creates capital gains taxes for shareholders and makes the index fund less tax efficient. That is one reason why I suggested in a recent article on passive index investing that I prefer something like Vanguard's Total Stock Market Index Fund (MUTF:VTSAX) to the Vanguard S&P 500 Index Fund (MUTF:VFIAX), as the total stock market fund is more tax efficient by not being forced to sell stocks to match a categorical index.

In any case, I hope readers find this article informative and of value when thinking about stocks they are considering as investments, and to pay attention to companies that are practicing creative destruction as a means to thrive in a rapidly changing technological landscape.

Disclosure:The author is long PG, VFIAX.The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.